Defining Penny Stocks and Why does it matter?

No universally accepted definition of the termpenny stockexists. Instead, folks in the financial sector categorize these low-priced shares in a variety ways, depending on who is doing the defining and why. What one trader may consider a penny stock may not qualify as such under another person’s definition.

In the following posts I walk you through the three major ways that investors typically distinguish penny stocks from their more expensive counterparts.

Price per share

Price per share is the most common (and simplest) criteria for identifying penny stocks. Many people apply the tag to any shares trading at one dollar or less. For others, the price range includes stocks trading as high as three or even five dollars per share.

The closest definition to actually being “official” is that of the Securities and Exchange Commission (SEC), which identifies shares trading at five dollars or less as a penny stock. Following the SEC’s lead, almost all stockbrokers and professional investors have adopted the same criteria, and I have as well. So, for the purposes of this website, I consider penny stocks to be any shares that trade at five dollars or less.

The primary drawback with using this definition is that price fluctuations can move the stock below and above the threshold level. What started out as a penny stock in the morning could trade above the threshold price at noon and then fall back below it an hour later.

Market capitalization

Market capitalization(market cap,for short), refers to the total value of a company, which is derived by multiplying the total number of shares available by the price per share. For example, if a company has two million shares valued at two dollars each, the market cap of the company is four million dollars. Some investors like to consider companies with market caps of less than $10 million to be penny stocks, while others use a cutoff point of $25 million, or $100 million, or an even great number.

Using market capitalization to define penny stocks is more involved than simply looking at the price per share. Also, because the underlying share prices and the total market cap continually change, it can make for more work when identifying penny stocks. Using market cap may also lead to situations in which a company trading at one cent per share isn’t considered a penny stock (due to the company having an extraordinarily large number of shares outstanding).

Most investors don’t use market capitalization as a method to define penny stocks. However, some prefer to focus their holdings on companies of a certain size for the implied stability that comes with larger businesses, and in such a case they may find the market capitalization approach helpful.

A Penny Stock in Their Past

Many people are surprised to find out just how many successful companies have been considered penny stocks at some point in their past.

Penny stocks have included the Ford Motor Company, Sirius satellite radio, American Airlines, Nokia, Lucent Alcatel, and many other recognizable names. In other words, these low-priced shares aren’t necessarily the junky companies you may have been led to believe!

Stock market

Some choose to label all companies trading on lower-quality stock markets with the penny stock moniker. For example, any company listed on the Pink Sheets may be considered a penny stock, even if its shares are trading at $90 each and its market cap is in the billions.

Mix and match

In some cases, investors may combine more than one of the previous criteria when defining a penny stock. For example, they may decide that any company trading on the Pink Sheetsandwith a share price of less than two dollars is a penny stock.

Why does it matter?

You may wonder why the definition of penny stock matters at all. For most people, and in most cases, it doesn’t. However, the distinction can have significant implications in certain circumstances:

Broker restrictions and fees:Stockbrokers often have special rules for low-priced shares. Some don’t allow their customers to purchase any penny stocks, while others charge much higher commissions for penny stock trades. Because most brokers define penny stocks as shares trading at five dollars or less, these parameters have implications on a significant number of investments.

Option eligibility:Certain shares are considered “option eligible” by the stock exchanges and stockbrokers. The criteria is usually based on a share price of at least five dollars, and it allows trading on margin (buying the stock with borrowed money), short selling (selling the shares and then buying them back later), and options trading in the particular company.

Portfolio balancing:An individual investor, or a professional such as a hedge fund trader or mutual fund manager, may only want a certain portion of her total portfolio to be in more speculative or volatile shares such as penny stocks. If she realizes that she has too much or too little of a percentage in one investment size or type, she will rebalance her holdings through the appropriate trades. Of course, she needs to have a criterion for what constitutes a low-priced share in order to manage her holdings.

Listing requirements:The stock exchanges have very specific requirements for any company whose shares are traded on them. Those requirements vary from one exchange to the next and generally get more demanding the better the exchange. Some of the criteria involve share price and market cap, and they typically exclude penny stocks. Penny stocks usually start trading on lower-level exchanges with easier parameters for inclusion.